Republican plans to cut corporate taxes may have unpleasant side-effects

SINCE Donald Trump won America’s presidential election investors have salivated over the prospect of lower taxes. Mr Trump has promised to cut corporation tax, a levy on firms’ profits, from 35% to 15%. Republicans remain in charge of both houses of Congress; Paul Ryan, the speaker of the House of Representatives, wants to cut the levy to 20%. The coming reforms, though, are about more than just lower rates. Republicans want to overhaul business taxes completely. Unfortunately, this task is far from straightforward.America’s corporate-tax rate, which reaches 39.6% once state and local levies are included, is the highest in the rich world. But a panoply of deductions and credits keeps firms’ bills down. These include huge distortions, such as a deduction for debt-interest payments, as well as smaller scratchings of pork like special treatment for NASCAR racetracks. After all the deductions are doled out, corporate-tax revenues are roughly in line with the average in the rest of the G7, according to economists at Goldman Sachs.Still, a high tax rate and a narrow tax base is a glaringly inefficient combination. Politicians of all...Continue reading SINCE Donald Trump won America’s presidential election investors have salivated over the prospect of lower taxes. Mr Trump has promised to cut corporation tax, a levy on firms’ profits, from 35% to 15%. Republicans remain in charge of both houses of Congress; Paul Ryan, the speaker of the House of Representatives, wants to cut the levy to 20%. The coming reforms, though, are about more than just lower rates. Republicans want to overhaul business taxes completely. Unfortunately, this task is far from straightforward. America’s corporate-tax rate, which reaches 39.6% once state and local levies are included, is the highest in the rich world. But a panoply of deductions and credits keeps firms’ bills down. These include huge distortions, such as a deduction for debt-interest payments, as well as smaller scratchings of pork like special treatment for NASCAR racetracks. After all the deductions are doled out, corporate-tax revenues are roughly in line with the average in the rest of the G7, according to economists at Goldman Sachs. In this section Republican plans to cut corporate taxes may have unpleasant side-effects The financial markets in an era of deglobalisation An early salvo in a trade war between America and China? Italy’s biggest bank unveils a recapitalisation plan The Asian Development Bank tries to evolve A cheaper currency does not always boost economic growth European insurers and the curse of low interest rates Do fiscal rules work in emerging markets? Venezuela’s lunatic experiment in demonetisation Place-based economic policies as a response to populism Reprints Related topics Goldman Sachs Taxes Public finance G7 (Group of Seven) United States Still, a high tax rate and a narrow tax base is a glaringly inefficient combination. Politicians of all stripes have sought to improve things. For instance, since 2012 Barack Obama has proposed cutting the rate to 28%, while doing away with (mostly unspecified) tax breaks. That idea never got a look in. But analysts are poring excitedly over Mr Ryan’s plan, which is for now the most detailed Republican offering. It proposes to expand the tax base in two main ways. The first is to kill off the deduction for debt interest, putting a welcome end to the incentive for companies to binge on debt. The savings from this would be spent on letting businesses deduct the full cost of their investments when they make them, however they are financed. The second concerns geography. Uniquely in the G7, America taxes firms’ global profits (net of any payments to foreign taxmen). But companies need pay only when they bring profits home, so they keep cash overseas—some $2.6trn-worth, by one estimate. Some escape Uncle Sam’s clutches altogether by merging with a foreign company and moving to its tax jurisdiction (although the Obama administration has penned rules making such “inversions” harder). Mr Trump wants to offer a one-time tax rate of 10% to firms that repatriate their cash. To put an end to the barmy incentives, Mr Ryan, adopting a pet cause of Kevin Brady, chairman of the influential House Ways and Means Committee, would stop taxing foreign profits. In fact, he wants to ignore foreign activity altogether, including profits made selling American goods abroad. Meanwhile, firms would no longer be able to knock off the cost of imported goods when adding up their profits. In combination, these two changes are dubbed “border adjustment”. This would make America’s corporate tax very similar to a value-added tax (VAT), a kind of border-adjusted sales tax, says Kyle Pomerleau of the Tax Foundation, a think-tank. Most rich countries have both a VAT and a corporate tax (see table). When, say, Rolls-Royce exports a jet engine from Britain to France, it pays French VAT on the sale and British corporate tax on its profits. But while America levies the corporate tax on exporters’ profits, it imposes no VAT on imported goods (except for state and local sales taxes). Mr Ryan’s proposal would more or less reverse this. Border adjustment penalises imports and subsidises exports. So some hope it would help to close the trade deficit. Mr Trump has often complained about the VAT Mexico imposes on American goods, when Mexican exports flowing north incur no such levy. America is “the only major country that taxes its own exports,” lamented Mr Brady in June. Economists are suspicious of these complaints. In theory, border adjustments do not affect trade, because export subsidies and import taxes both push up the dollar. So imports are taxed more, but get cheaper. Exports escape tax, but get pricier. In combination, the currency and tax effects should balance exactly. In reality, it might take time for the dollar to rise. If so, American exporters would benefit in the interim. But big importers would take a hit. The Retail Industry Leaders Association, a trade group, is already campaigning against the change. However long the dollar took to appreciate, it would be no small adjustment. To offset a border-adjusted tax of 20%, the greenback would have to rise by a staggering 25%, according to Goldman. It is already up by 24% on a trade-weighted basis since mid-2014; repeating that appreciation would hammer those emerging markets with sizeable dollar-denominated debts and threaten the health of the world economy. It would also reduce the dollar value of American investments abroad. Despite the plan’s appealing simplicity, it seems unlikely that Congress will pass a proposal that would cause such volatility in currency markets. Senate Republicans have been largely mum on the House plan. And unless America switches to a full-fledged VAT, border adjustability may also be judged to breach World Trade Organisation rules. That bodes ill for the size of the overall corporate-tax cut. Since America imports much more than it exports, border adjustability would raise fully $1.2trn over a decade, covering almost two-thirds of the cost of cutting the tax rate to 20%, according to the Tax Policy Centre, a think-tank. Without that money, Republicans would have to scale back their plans, disappointing investors. And it might force the government to borrow more, widening the budget deficit, and putting short-term upward pressure on the dollar. Either way, markets could be in for a few surprises yet.

 

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